Weekly Chart: US Yield Curve vs. VIX (log, 30M lagged)

As a response to the recent surge in the market’s volatility (VIX), we saw lately an interesting chart that plots the 2Y10Y yield curve overlaid with the VIX (log, 30-month lagged). Even though we don’t necessarily agree with the fact that yield curves are a good predictor of recessions, we like to integrate it in our analysis as a supportive argument when presenting our outlooks as it summarizes a lot of information in a single chart. Previously, we presented the SP500 index versus the 2Y10Y yield curve (here), in which we emphasized that US equities can continue to rise (as the fundamental indicators) for weeks (2000) or months (2006/2007) despite a negative yield curve.

In this chart, we can notice another important factor, which is that the bull momentum in the equity market can persist even though market experiences an increase in price volatility (on an implied base). For instance, in the last two years of the 1990s (98/99), the VIX averaged 25%, 10 percent higher than in the last few years, while the SP500 was up 70% (the Nasdaq actually increased by 100% in the last quarter of 1999).

Hence, if we assume that the 25-year relationship between equity volatility and the business cycle holds on average, the constant flattening US yield curve over the past 2 years was suggesting a rise in the VIX.  The chart shows the persistent divergence between the two times series prior the sell-off; while the 2Y10Y had flattened by 200bps to 0.50% over the past couple of years, the VIX was averaging 10-12. The question now is: what to expect in the future for US equities, volatility and yields?

With the 10-year slowly approaching the 3-percent threshold, are US equities and volatility sensitive to higher long-term yields? As Chris Cole from Artemis pointed out in his memo Volatility and the Alchemy of Risk, there is an estimated 2tr+ USD Global Short Volatility trade (i.e. 1tr USD in risk parity and target vol strategies, 250bn USD in risk premia…). Can we experience another late 1990s period with rising LT yields, higher implied volatility without a global deleveraging impacting all asset prices?

In our view, it is difficult to see a scenario with rising LT yields combined with an elevated volatility (i.e. 20 – 25 %) without a negative impact on overall asset classes. Hence, if we see a persistent high volatility in the medium term as this chart suggests, the deleveraging in both bonds and equities by investment managers will kickstart a negative sell-reinforcing process, creating a significant sell-off in all asset classes with important outflows in the high-yield / EM investment world, hence leading to a repricing of risk.

Chart. US 2Y10Y Yield Curve vs. VIX (log, 30M lagged) (Source: Eikon Reuters)

USYield vs VIX

Weekly Chart: Relative Implied Volatility – VIX/RVX ratio

For each investor, there are several ways of measuring the market’s temperature. For instance, former Fed chairman Alan Greenspan would look at the 10-year US yield, some investment managers will simply look at the VIX and currency traders will tend to watch the moves on the Japanese Yen, especially against the US and Australian Dollar (see AUDJPY and SP500 correlation here). We know empirically that a sudden move on the Yen (JPY appreciates relative to other currencies) is usually accompanied with an equity correction and hence an increase in the implied volatility. Even though we hear a lot about the VIX measure, we also need to pay attention to the implied volatility surface, presenting skew/smiles features and term structure, and compare it relative to other equity markets and asset classes. For instance, a couple of measures we like to watch are the VIX/Skew (here) and the VIX/VXV (here) ratios.

Hence, in today’s article, we present the VIX/RVX, which measures the ratio between the implied volatility of the SP500 and the Russell 2000, a small-cap stock market index. As you may know, the ‘small cap premium’ has been a crowded study in the empirical academic research, which started from the early work of Rolf Banz (1981) who founded that ‘smaller firms have had higher risk-adjust returns, on average, than larger firms’. Then, in their paper The Cross-Section of Expected Stock Returns (1992), Fama and French found that value and small cap stocks, on average, outperform growth and large carp stocks. As you can see it on the chart, an interesting development has occurred over the past few days following the huge spike in volatility. The VIX/RVX, which has constantly been above parity since 2006, is now sitting at 0.83. In other words, according to the index, the Russell 2000 equity market carries less risk than the SP500. The question now is: what explains this sudden drop in the ratio?

If we look at the week-on-week change in both indexes, we can first notice that, at current levels, the WoW change of 11.6 in the VIX came in at 5th position in the index history, just a 0.3 ‘shy’ of the October 1997 move (here). However, if we now look at the change in the implied volatility of the small caps, the RVX index barely changed (+2.3) over the past week, meaning that the drop in the ratio was only coming from the VIX move (here).

Hence, this leads us to an interesting conclusion: it seems that there is much more financialization going on with the VIX than with the RVX, either through the creation of single and double-levered long and short VIX ETFs products, or from a volatility-targeting and risk-parity perspectives (are those strategies more oriented towards the SP500?).

Chart: Relative Implied Volatility – VIX / RBX ratio (Source: Eikon Reuters)

Eyes on Yellen (and global macro)

As we are getting close to the FOMC statement release, we were reading some articles over the past couple of days to understand the recent spike in volatility. Whether it is coming from a ‘Brexit’ fear scenario, widening spreads between core and peripheral countries in the Eurozone (German 10Y Bund now trading negative at -0.5bps), disappointing news coming from US policymakers this evening or more probably from something that we don’t know, we came across some interesting data.

First of all, we would like to introduce an indicator that is getting more and more popular these days: Goldman’s Current Activity Indicator (CAI). This indicator gives a more accurate reflection of the nation’s GDP and can be used in near real-time due to its intra-month updates. It incorporates 56 indicators, and showed a 1-percent drop in May to 1.2% due to poor figures in the labor market and ISM manufacturing data (see chart below).

Chart 1. Goldman CAI (Source: Bloomberg)

The implied probability of a rate hike tonight is less than 2% according to the CME Group FedWatch, and stands only at 22.5% for the July meeting. If we have a look at the Fed Dot Plot’s function in Bloomberg, we can see that the implied FF rates curve has decreased (purple line) compare to where it was after the last FOMC meeting (red line), meaning that the market is very reluctant to a rate hike in the US.

Chart 2. US Feds Dot Plot vs. Implied FF rates (Source: Bloomberg)

June hike, why not?

Many people have tried to convince me of a ‘no June hike’ scenario, however we try to understand why it isn’t a good moment for Yellen to tighten. Oil (WTI CL1) recovered sharply from its mid-February lows ($26/bbl) and now trades slightly below $48 (decreasing the default rate of the US high-yield companies), the US Dollar has been very quiet over the past 18 months (therefore not hurting the US companies’ earnings), the SP500 index is still trading above 2000, the unemployment rate stands at 4.7% (at Full employment) and the Core CPI index came in at 2.1% YoY in April.

However, it seems that US policymakers may have some other issues in mind: is it Eurozone and its collapsing banking sector, Brexit fear (i.e. no action until the referendum is released), CNY series of devaluation or Japanese sluggish market (i.e. JPY strength)?

The negative yield storm

According to a Fitch analysis, the amount of global sovereign debt trading with negative yields surpassed 10tr USD in May, with now the German 10Y Bund trading at -0.5%bps. According to DB research (see chart below), the German 10Y yield is the ‘simple indicator of a broken financial system’ and joins the pessimism in the banks’ strategy department. It seems that there has never been so much pessimism concerning the market’s outlook (12 months) coming from the sell-side research; do the sell-side firms now agree with the smart money managers (Carl Icahn, Stan Druckenmiller, Geroge Soros..)?

Chart 3. German 10Y Bund yield (Source: DB)

10Y bund DB.jpg

ECB Bazooka

In addition, thanks to the ECB’s QE (and CSPP program), there are 16% of Europe’s IG Corporate Bonds’ yield trading in negative territory, which represents roughly 440bn Euros out of the outstanding 2.8tr Euros according to Tradeweb data. If this situation remains, sovereign bonds will trade even more negative in the coming months, bringing more investors in the US where the 10Y stands at 1.61% and the 30Y at 2.40%. If we look at the yield curve, we can see that the curve flattened over the past year can investors could expect potentially LT US rates to decrease to lower levels if the extreme MP divergence continues, which can increase the value of Gold to 1,300 USD per ounce.

Chart 4. US Yield Curve (Flattened over the past year)


(Source: Bloomberg)

Poor European equities (and Banks)

However, it seems that the situation is still very poor for European equities, Eurostoxx 50 is down almost 10% since the beginning of June, led by the big banks trading at record lows (Deutsche Bank at €13.3 a share, Credit Suisse at €11.70 a share). The situation is clearly concerning when it comes to banks in Europe, and until we haven’t restructured and/or deleveraged these banks, systemic risk will endure, leaving equities flat (despite 80bn Euros of money printing each month). Maybe Yellen is concerned about the European banks?


Another issue that could explain a status quo tonight could be the rising fear of a Brexit scenario. According to the Brexit poll tracker, leave has gained ground over the closing stages, (with 47% of polls for ‘Brexit’ vs. 44% for ‘Bremain’). This new development sent back the pound to 1.41 against the US Dollar, and we could potentially see further Cable weakness toward 1.40 in the coming days ahead of the results. Many people see a Brexit scenario very probable, raising the financial and contagions risks and the longer-term impact on global growth. It didn’t stop the 10Y UK Gilt yield to crater (now trading at 1.12%, vs. 1.6% in May), however a Brexit surprise could continue to send the 5Y CDS to new highs (see below).

Figure 1.  FT’s Brexit poll tracker (Source: Financial Times)


Chart 5. UK 5Y CDS (Source: Bloomberg)


CNY devaluation: a problem for US policymakers?

Eventually, another problem is the CNY devaluation we saw since the beginning of April. The Chinese Yuan now stands now at its highest level since February 2011 against the greenback (USDCNY trading at around 6.60). we are sure the Fed won’t mention it in its FOMC statement, but this could also be a reason for not tightening tonight.

Conclusion: a rate hike is still possible tonight

To conclude, we are a bit skeptical why the market is so reluctant for a rate hike this evening, and we still think there is a chance of a 25bps hike based on the current market situation. We don’t believe that a the terrible NFP print (38K in May) could change the US policymakers’ decision. Moreover, even though we saw a bit of volatility in the past week (VIX spiked to 22 yesterday), equities are still trading well above 2,000 (SP500 trading at 2,082 at the moment) and the market may not be in the same situation in July or September.

Ahead of the ECB and Fed meetings: watch the VIX

In this very quiet week, the SP500 is once again ‘playing’ with the 2,100 level and we strongly believe that it could be a perfect time to go short if you think about the upside / downside risk. There are many events coming up starting with the ECB meeting tomorrow and Non-Farm Payrolls on Friday. We guess we could see some volatility coming from these events which could impact equities and the FX market. As we wrote here, we saw that usually EURUSD tends to be positively correlated to sudden rise in volatility. Even though we expect the ECB to keep its rates steady (deposit at -0.4%, refi at 0% and marginal lending facility at 0.25%) with no increase in the current 80-billion-euro QE program, the market may react negatively during Draghi’s conference starting 1.30pm. Once again, the ECB could disappoint, leading to equities sell-off and some Euro appreciation. As you can see it in the chart below, EURUSD has entered in a bearish trend since May 3rd, decreasing by 5 figures until it hit its 200-SMA (yellow line) at 1.11. It has been trading within a 90-pip range over the past 3 days and we expect the currency pair to stay rangy today as well; however we would pay attention to the potential spike we can see tomorrow. The first strong resistance on the upside stands at 1.1250, a breakout could directly lead us towards the 1.1350 – 1.1400 range.


(Source: Bloomberg)

In addition, US non-farm payrolls could disappoint on Friday (Bloomberg survey at 160K) leading to another round of equity sell-off, sending the US 10-year yield back below 1.8% and pushing the Euro to higher levels. If we look back at the beginning-the-year sell-off in the chart below, the SP500 (candlesticks) fell by more than 200pts, the US 10-year (red line) crashed from 2.3% to 1.66% while the Euro (green line) surged by 7 figures to almost 1.14 against the greenback.


(Source: Bloomberg)

Another reason to go short US equities at the moment could be a good strategy to hedge yourself against a volatility spike ahead of the FOMC meeting (June 14/15). If we look at the FedWatch Tool developed in the CME website, there is a 22.5% implied probability of a rate hike based on the CME 30-day Fed Funds futures prices.


(Source: CME Group)

However, the odds are higher based on the last few speeches delivered by US policymakers and of course a quiet market. In her 30-minute Q&A session with Greg Mankiw at Harvard on Friday, Fed Chairman Yellen said that the economy was continuing to improve and that a ‘rate hike in coming months may be appropriate’. In ouropinion, we think a June move is appropriate, especially if equities still trade above 2,000 until that meeting. In addition, if we look at the Eurodollar futures market, time deposits denominated in US dollars and held at banks outside of the United States, the June contract trades 99.28 (i.e. the implied rates is at 72bps). Eurodollar contracts are useful to look at as well as they are more liquid than Fed Funds futures.

The only reason we see no rate hike this meeting is if we experience another sharp sell off within the next couple of weeks.

A Euro update ahead of the ECB meeting

As we are in the middle of a market turmoil, with equities down 10 to 15 percent since the beginning of the year, we thought that a quick update on the Euro (and where it is going) could do it. With Eurostoxx index down 12% and peripheral sovereign and financial risk spiking (Banca Monte Paschi di Siena down 60%, trading at 51 cents), markets’ participants are questioning themselves ‘what more could the ECB do?’ Currently on a €60bn bond-purchases program (which duration was extended to March 2017) combined with a NIRP policy (deposit rate at -0.3%), there is not much that Draghi could offer to the market in order to depreciate the single currency to lower levels (parity?) and stabilize the market.

Since the Euro’s recovery when Draghi’s credibility was threatened at the December’s meeting (no increase in the asset purchase programme), EURUSD has been trading sideways over the past 6 weeks within a 350-pip range (1.07 – 1.1050). It looks like the single currency is struggling to break trough the 1.10 strong resistance, and We believe that a lot of bears are waiting to go short around that area. However, we would be cautious on a new disappointing news coming from the ECB that could potentially send EURUSD to new highs. Unless the Governing Council reveals a new plan to stabilize the Euro Zone economy and its stagnating inflation rate (+0.2% in December), there are no main reasons why the Euro should decline drastically tomorrow. One chart that we like to watch when volatility spikes is EURUSD and its correlation with the VIX index. As you can see it on the chart below, the 10-day correlation has moved from 0 to 74% over the past two weeks, with the VIX index trading slightly below 30. We think it could be interesting to watch the overnight session and its impact on tomorrow’s trading session, as we know that the single currency can act as a safe haven asset in periods of high volatility (and low liquidity). The last time was on August 24th as we wrote it in our article EURUSD and VIX last September.


(Source: Bloomberg)

Global Macro: trade on China’s weak signs and Draghi’s Will to Power

This article deals with a few current hot topics:

  • The main one gives an update on weakening signs of giant China
  • The second one reviews the ECB Thursday’s meeting, presented with a couple of FX positioning
  • The last one is on the debt ceiling debate and risk-off sentiment

China desperately flowing…

As I am looking at the current news in the market, there has been a lot of interesting topics to study over the past couple of months. I will first start this article with an update on China and its weakening economy. Since the Chinese ‘devaluation’ on August 11th, I have been focusing much more in the EM and Asian Market as I strongly believe that the developed world is not yet ready for a China & Co. slowdown. I heard an interesting analysis lately, which was sort of describing the assets that had performed since the PBoC action more than two months ago. As you can see it on the chart below, Gold prices (XAU spot) accelerated from 1,100 to a high of 1,185 reached on October 14th, and Bitcoin recovered from its low of 200 reached in late August and now trades at $285 a piece.


(Source: Bloomberg)

One additional explanation that I have for Gold is that I believe that the 1,100 level could be an interesting floor for long-term investors interested in the currency of the last resort. The weak macro, loose monetary policy, low interest rates and more and more currency crisis in EM countries will tend to bring back gravity in Gold, especially if prices become interesting (below $1,100 per ounce) for long-term buyers.

Looking at the CSI 300 Index, we still stand quite far from the [lower] historical high of 5,380 reached in the beginning of June last year. Since then, as a response, we had a Chinese devaluation, the PBoC cutting the minimum home down payment for buyers in cities last month (September 30th) from 30% to 25% due to weak property investment, and then a few days ago the PBoC cutting the Reserve Requirement Ratio (RRR) for all banks by 50bps to 17.50% and its benchmark lending rate by 25bps to 4.35%. Looking at all these actions concerns me on the health of the Chinese economy; it looks very artificial and speculative. In a late article, Steve Keen, a professor in economics explained that the Chinese private-debt-to-GDP ratio surged from 100% during the Great financial crisis to over 180% in the beginning of 2015, amassing the largest buildup of bad debt in history. Its addiction to over expand rapidly have left more than one in five homes vacant in China’s urban areas according to the Survey and Research for China Household Finance. Banks are well too exposed to equities and the housing market, and it looks that they have now started a similar decline as the US before 2008 and Japan before 1991. To give you an idea, the real estate was estimated to be at 6% of US GDP at the peak in 2005, whereas it represents roughly 20% of China’s GDP today.


(Source: Forbes article, Why China Had to Crash)

I wrote an article back last September where I mentioned that the Chinese economy will tend to slow down more quickly than analyst expect, therefore impacting the overall economy. We saw that GDP slide to 6.9% QoQ in the third quarter, its slowest pace since 2009 and quite far from the 7.5%-8% projection in the beginning of this year.

Draghi’s Will To Power

One fascinating event this week was the ECB meeting on Thursday. Despite a status quo on its interest rate policy, leaving deposit rate at -0.2% and the MRO at 5bps, a few words from the ECB president drove immediately the market’s attention. He said exactly that ‘The degree of monetary policy accommodation will need to be re-examined at our December policy meeting’, therefore implying that the current 1.1 trillion-euro program will be increased. As you can see it on the chart, EURUSD reacted quite sharply, declining from 1.1330 to a low of 1.0990 on Friday’s trading session, and sending equities – Euro Stoxx 50 Index – to a two-month high above 3,400. Italy 2-year yield was negative that day (hard to believe that it was trading above 7.5% in the end of November 2011).


(Source: Bloomberg)

 I am always curious and excited to see how a particular currency will fluctuate in this kind of important events (central banking meeting usually). One thing that I learned so far is to never be exposed against a central bank’s desire; you have two options, either stay out of it or be part of the trend.  I think EURUSD could continue to push to lower levels in the coming days, with the market slowly ‘swallowing’ Draghi’s comment. I think that the 1.0880 level as a first target is an interesting level with an entry level slightly below 1.1100 (stop above 1.1160).

USDJPY broke out of its two-month 119 – 121 in the middle of October down to almost 118, where it was considered as a buy-on-dip opportunity. It then levitated by 3 figures to 121.50 in the past couple of weeks spurred by a loose PBoC and ECB. The upside looks quite capped in the medium term if we don’t hear any news coming from the BoJ. The upside move on USDJPY looks almost over, 121.75 – 122 could be the key resistance level there.


(Source: Bloomberg)

Potential volatility and risk-off sentiment coming from the debt ceiling debate

On overall, with US equities – SP500 index – quietly approaching its 2,100 key psychological resistance with a VIX slowly decreasing towards its 12.50 – 13 bargain level, I will keep an eye on the debt ceiling current debate in the US, which could trigger some risk-off sentiment in the next couple of weeks (i.e cap equities and USDJPY on the upside). Briefly, the Congress has to agree on raising the debt limit to a new high of 19.6tr USD proposed (from 18.1tr USD where it currently stands). The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing obligations, and the current debt ceiling proposal’s deadline is November 3rd. No agreement would mean that the US government could default on its debt obligations, which could potentially increase the volatility in the market.

The chart below shows the increase of the debt ceiling since the early 1970s, after the Nixon Shock announcement which led to the end of Bretton Woods and the exponential expansion of credit.


(Source: The Burning Platform) 


The chart below shows a quick analysis of EURUSD and VIX Index over the past six months. As you can see, the 20-day correlation between the two underlying assets has switched from a negative 80 in Mid-March to a positive 80.6% today. If you are a global macro trader, I personally believe that it is important to notice those changes between different asset classes, so you can see how a particular currency will react in case of a volatile day.

During the ‘Black Monday’ session this year (August 24th), the VIX Index soared above 40 and one of the surprising assets rallying was the Euro. On that day, EURUSD surged above the 1.17 level, up 350 pips in a few hours. Sell-side research started to call it the New Safe-Haven Currency, therefore reviewing its 3-month and 6-month to the upside.

Keep a small long EURUSD in your book ahead of the FOMC

In my opinion, I think it could be good to keep a long position on EURUSD ahead of the FOMC meeting this evening in case we see a bit of volatility.

Based on the macro situation in the US, a persistent moderate nominal growth and a poor core PCE deflator at 1% (Bloomberg PCE MBXYH Index), I think a no-hike scenario will make more sense. However, a 25bps is still in the game and wouldn’t have dramatic consequences for the market; but in that case, we could see a bit of equity sell-off, a higher VIX and therefore a higher EURUSD. An interesting level on the upside will be 1.1380; a break out could potentially bring EURUSD to 1.1450. On the downside, 1.1220 is the key level where I should potentially keep a safe stop.


(Source: Bloomberg)

The VIX/VXV Ratio

Last time, we talked about the convergence and divergence between the VIX and SKEW and what sort of information we could get from that. Today, let me introduce you to the VIX/VXV ratio combined with an application on the US Stock market.
But first, let’s start with the definitions of all the indexes:

– As a reminder, the ‘SKEW’ is an indicator that computes the implied volatility of the S&P500 from OTM the options and therefore ‘measures fat tails’ and investors fear.

– The VIX index, introduced in 1993 by the Chicago Board Options Exchange (CBOE), measures the 30-day volatility implied by the ATM S&P500 option prices. The components of the VIX are basically near/next – term put and call options.

– The VXV index (that you can also find in Bloomberg) is designed to be a constant measure of 3-month implied volatility of the S&P 500. It uses the same methodology and generalized formula as the VIX index.

If you are familiar with the term structure, investors and traders can use the historical data of the last two indexes (VIX and VXV) in order to gain a better understanding of the market’s expectations of the future volatility. As you can see it on the graph below, for the past few years (December 11 – June 14), the VIX/VXV ratio (in green) has been oscillating around 0.85 – 0.90 with a low of 0.71 (16-Mar-12) and a high of 1.0645 (02-Mar-14). The ratio has remained most of its time below 1.00, which is logical as the term structure should have an increasing concave shape (in theory). Basically, a ratio superior to one would mean that investors are more concerned about the near term fluctuations (usually a correction) of the S&P500 and often comes from an appreciation of the VIX due to market events such as FOMC meetings or companies’ earnings.


(Source: Bloomberg)

In the graph, I drew a white line which has (‘kinda’) acted as a support for the VIX-to-VXV ratio (around 0.82). However, when I look at the S&P500 chart (white/blue), I can see that most of the times that we hit this ‘imaginary’ resistance, the ratio rebounded and we either saw a stagnation or correction in the stock market (correct me if I am wrong).

For those who don’t agree with me concerning the application (and I can accept that), they just to have to remember that the VXV provides a valuable tool for traders to indentify the term structure of S&P 500 implied volatility and that a single value of the (SPX option) implied volatility is not enough.

CBOE Skew vs. VIX

Today, I would like to speak about the convergence and divergence between the SKEW and the VIX. I guess that everybody is familiar with the VIX that reflects a market estimate of future volatility (introduced in 1993 by the Chicago Board Options Exchange – CBOE, measures the 30-day volatility implied by the ATM S&P500 option), however let me introduce you to the CBOE SKEW index.

Since the crash of October 1987 (Black Monday, DJ down 22.6%), investors have realized that S&P500 tail risk (returns that are under 2 or more standard deviations below the mean) is significantly greater than under a lognormal distribution. Therefore, the ‘skew’ measures the perceived tail risk of the market via the pricing of OTM options. A rise in skew indicates that ‘crash protection’ is in demand among institutional investors (also called the ‘big players’ in the SPX options market).
A ‘low VIX/high skew’ combination says that the market is complacent, however the ‘big players’ perceive far more tail risk than usually. Therefore, a surprise increase in realized volatility may not be too far away.

If we have a look at the chart below (which represents in fact the VIX and the SKEW), we can see that VIX (green) is sitting at very low levels at the moment (13.57%) and may need to release some ‘energy’. In blue, we have the Skew index which has been fluctuating within the 125 – 130 range for the past few weeks (now trading at 129.25). I recommend you closely watch your positions when the index is approaching the high of the ‘historical’ 100 – 150 range.


(Source: Bloomberg)

If you extend the historical chart since 1990, you can see that the perception of increased tail risk can be early (skew was above 130 level in 2005 already while the VIX was trading at 10.0 at that time), but it definitely remains one the ‘fear’ indicators watched by Wall Street players (with CSFB – Credit Suisse Fear Barometer – index).